NEW YORK LAW JOURNAL SPECIAL REPORT Corporate Restructuring & Bankruptcy www. NYLJ.com

Volume 262—NO. 59 MONDay, september 23, 2019 Navigating the Apocalypse

BY Bradford J. Sandler and Jonathan J. Kim

he substantial stress facing the retail industry has caused T thousands of store closures over the last several years, and dozens of retail bankruptcies. The “retail apocalypse” is not over, and numerous factors and circumstanc- es suggest that retailers’ struggles and difficulties will persist. Some have prognosticated that brick SHUTTERSTOCK and mortar is dead; it is not dead, although the physical shopping Various circumstances point to Toys R Us, Shopko, Claire’s, to experience is changing. retailers’ rough times continuing name a few). at least in the short run. Accord- Generally, statistics are not on the State of the Industry ing to a recent S&P Global analy- side of successful retailer reorgani- There have been nearly 20 large sis, the credit ratings of 17% of zations. For example, between 2006 retailer bankruptcies as of mid- retailers covered by S&P Global and most of 2017, nearly half of retail 2019 including Barney’s, Payless are at distressed levels. Further, bankruptcies with more than $50 Shoes, and Gymboree, compared retailers and observers are wary million in liabilities ultimately ended to 25 such bankruptcies in 2018, of potential negative repercus- in liquidation, as opposed to a reor- 37 in 2017, and 18 in 2016. Based sions of tariffs and international ganization or going concern sale; on Debtwire data, from 2016 to mid- trade tensions that could lead to in contrast, according to AlixPart- 2019, more than 100 larger retailers higher inventory costs and lower ners Retail Bankruptcy Study, less ($50 million+ in liabilities) filed for earnings. Many of the large retailer than 10% of larger debtors in other bankruptcy. bankruptcies in 2018 and so far in industries ended in similar manner. 2019 were of private equity owned In some cases, the retailer Chapter Bradford J. Sandler is a partner and Jona- or formerly private equity backed 11 started out with an eye towards than J. Kim is counsel at Pachulski Stang Ziehl & Jones. companies (e.g., Payless, , reorganization, but then ended up Monday, September 23, 2019 as a liquidation (e.g., The Sports Bankruptcy Costs leases, as well as extricate itself Authority, hhgregg). And Benefits from unfavorable logistics, trans- Filing for bankruptcy protection portation, and marketing contracts Causes of Distress In the Retail Industry offers various benefits for struggling more efficiently. retailers, including authorizing the Importantly, the size of the debt- There are two main reasons for sale of retailers’ going concern busi- or’s go-forward, post-bankruptcy the current financial distress in ness or specific assets such as store store footprint must be reasonably the retail industry. First, there is locations, free and clear of liens and justified based on the debtor’s go- a substantial shift in consumption encumbrances, and the rejection forward business plan, projections, patterns away from brick-and- of poorly performing or otherwise access to funding, and other circum- mortar stores to online stores and undesirable store leases. stances. If the store footprint is not e-commerce. The second primary Rejection of Unfavorable Leases rationalized, the retailer may be in reason causing financial distress is and Contracts. The Bankruptcy the same or similar financial distress the level of retailers’ debt. Overall, Code gives a retailer the ability to in the future. For instance, various retailers typically have lower levels assume or reject unexpired leases, retailers have filed for “Chapter 22” of debt compared to most other as well as executory contracts. bankruptcy—a euphemism referring industries. However, as many of the Assumption means the debtor (i.e., to a company’s second Chapter 11 recent retailer bankruptcy cases retailer) agrees to perform under bankruptcy—like American Apparel, evidence, excessive debt (includ- the terms of the lease, provided it Wet Seal, and Payless. ing debt stemming from LBO and Asset Sales Free and Clear of dividend recapitalization transac- Generally, statistics are not on Encumbrances and Releases. In the tions) was and remains a problem the side of successful retailer past several years, the substantial among larger retailers. reorganizations. majority of retailer bankruptcy fil- Beyond these causes, there are ings were sale cases where a pre- other causes of distress, too, such as cures prior defaults and provides filing sale process was undertaken the slowness in management at reach- adequate assurance of future per- or started, or “free fall” emergency ing out to their landlords and supply formance, while rejection means filings. Further, according to Debt- chain to seek reasonable concessions; that the lease will end as a practical wire, during the past several years, the focus on cost-cutting, rather than matter as of the date of rejection. Bankruptcy Code §363 sales of the top line growth; or reluctance to right- Generally, the retailer debtor will debtor’s business or substantial size the retailer’s footprint by closing assume the leases for stores or assets were among the most com- poorly-performing stores; or simply locations where business opera- mon strategies to exit bankruptcy. misreading consumer preferences (a tions are profitable, and reject Sales of retailers’ assets pursu- la Gymboree or Aeropostale). In the those that do not contribute to the ant to Code §363 (or pursuant to end, if these issues are not addressed debtor’s profitability or fit within a plan of reorganization) may pro- head-on, they will lead to significantly the debtor’s go-forward business vide a number of benefits to a pur- diminished liquidity that will leave plan. Thus, the retailer will be able chaser, including (1) obtaining the the retailer significantly distressed to right-size its store footprint and assets free and clear of liens, (2) with few options. extricate itself from unfavorable protection against certain liabilities Monday, September 23, 2019 and certainty with respect to the under a Chapter 11 plan. An impor- fees will likely and should be. Further, enforceability of the transaction tant qualification to the foregoing is cost criticisms ignore or downplay documents as provided in the bank- that the retail debtor must pay all the significant value that case profes- ruptcy court’s order, (3) relief from Code §503(b)(9) claims (i.e., claims sionals often add to the retailer during the need to obtain consent to the arising from good provided to the the pendency of its Chapter 11 case assignment of certain leases and con- retailer within 20 days of the peti- by minimizing uncertainty, maximiz- tracts, (4) exemption from certain tion date), in their entirety (unless ing value and preserving jobs. state laws, including stockholder the supplier agrees otherwise), Another major disadvantage is approval requirements. Depending to emerge from bankruptcy, since how the retail debtor will be subject on all of the relevant circumstances, administrative priority claims must to myriad restrictions; operating in such benefits may come at a higher be paid in cash on the effective date bankruptcy may be viewed as “living purchase price, redounding to the of a plan (if not earlier if ordered by in a fishbowl.” The Bankruptcy Code benefit of the retailer’s estate and the court). and other applicable orders, rules creditors. If the sale is contemplated Post-Confirmation Fresh Start. and requirements may hinder the to be effectuated through a plan of Post-bankruptcy, the retailer may retailer’s operations, business plan, reorganization, the sale not only have a significant challenge in obtain- and transactions in some material would have the benefits just men- ing favorable trade terms from its respects, and the bankruptcy court, tioned, but also, among other things, suppliers post-confirmation; some creditors’ committee, the U.S. Trust- provide the protective benefit of get- vendors may demand COD or CIA ee, and other key players will closely ting a release in favor of directors and some may just jump ship and monitor the debtor and its activities. and officers, lenders and any equity cut off business relations with the Management of a stressed retailer sponsor. retailer, and a retailer cannot con- is faced with daily challenges, but Reducing Prepetition Debt. A pri- tinue for long on a COD/CIA basis or those challenges pale in comparison mary reason causing financial dis- if it develops an inventory shortage. to the challenges faced by manage- tress for many retailers is excessive In some retailer reorganization cases, ment of a distressed retailer. One debt—typically secured ABL (asset the debtor may try to incentivize its concern of any distressed retailer based loan) financing. In the retailer’s vendors to give favorable trade terms is the loss of key employees who Chapter 11 case, such debt is often after emergence from the bankruptcy are needed for a successful reor- reduced through paydown with bank- by, for example, the estate agreeing ganization. In order to keep the ruptcy sale proceeds, inventory liqui- to waive potential avoidance actions management team incentivized, it dation proceeds, or at times through and claims against such vendors, or is important for the Board to con- a debt-for-equity swap implemented giving those vendors an incentive sider structuring a proper incentive in a reorganization plan. payment. Further, the retailer having program that will motivate manage- In addition to secured financing an appropriate exit financing facil- ment to get the best outcome. claims, retail debtors also use the ity should ameliorate many vendors’ What Should a Retailer bankruptcy process to address their post-confirmation concerns as it can Do When in Stress? suppliers’ significant prepetition demonstrate it is well-capitalized. claims; such claims are typically Disadvantages of Filing for Bank- In general, a troubled retailer must general unsecured claims that often ruptcy. The larger and more complex act immediately and aggressively; receive relatively small recoveries the bankruptcy case, the greater the denial of the business’ financial Monday, September 23, 2019 and operational predicament and retailers have been overly bur- their analysis into tailored strategies the concomitant delay in address- dened with LBO, dividend recap, or taking into account, among other ing the retailer’s problems will be other related debts, which makes concerns: value destructive. The stressed a reorganization challenging. Even • customers’ changing and dif- retailer must undertake realistic, some apparently successfully reor- ferent demands and dynamics (g., expeditious, proactive strategies ganized retailers remain highly Millennials’ desire for convenience, including the following: leveraged (3-4 or more times pro- on-demand economy, etc.); Candid, Comprehensive Review: jected EBITDA) and vulnerable in • effective e-commerce opera- The retailer should evaluate all an extremely competitive business tions; areas of the company including environment. • omni-channel expansion and inventory management, Transparency/Consensus: The integration; strategy, and store footprint, retailer should be transparent with • supply chain and distribution and undertake a SWOT analysis the key stakeholders such as major management/network issues (in (Strengths, Weaknesses, Opportu- secured creditors, equity spon- response to Prime ship- nities, and Threats) to formulate sors, suppliers, store landlords, ping, customers’ demands for con- an action list. and unions. As noted above, a key venience, etc.); Attention to Top Line Growth factor in many successful retailer • active monitoring of the retail- in Addition to the Bottom Line: bankruptcies (such as True Religion er’s real estate portfolio and store The retailer should focus on both and Gymboree) is the speed with design; the top line and the bottom line. which the Chapter 11 case is pros- • consumer data issues; It is instinctive for management to ecuted and administered; transpar- • labor issues; and focus on the bottom line and cost ency and proactively working with • other macroeconomic issues cutting of rent, capital expendi- the key players will usually facilitate including potential inflationary pres- tures, employee head count and consensus and the reorganization sures, rising wages, U.S. immigration the like to improve performance, process. policies, and international trade and and often place inadequate focus Advisor Assistance: The retailer tariff wars. on top line growth. Management should promptly hire and utilize There may continue to be high should ask, among other questions, the appropriate legal and financial numbers of retailers filing for bank- does the current business model advisors to assist with the retailer’s ruptcy protection in the short term, work, or does a new model (e.g., analysis and action list, and to pro- based on macroeconomic and expanding product lines, product vide independent, expert advice. industry-specific developments, but improvements, store improvement, Most management are not familiar retailers that are proactive and com- revised footprint, new advertising with the challenges of stress or dis- prehensive in their approach will campaigns, incorporating new tech- tress and bringing on the right advi- be much more likely to avoid being nologies, etc.) need to be employed sors early can help to avert what a part of the “Retail Apocalypse.” to boost flat sales? otherwise could be an inevitable Workable Debt Level: The bankruptcy. retailer should review and right- To not only survive, but to be able size its debt level where possible. to thrive, retailers must undertake Reprinted with permission from the September 23, 2019 edition of the NEW YORK LAW JOURNAL © 2019 ALM Media Properties, LLC. All rights reserved. Further duplication without permission is prohibited. For information, contact 877-257-3382 As noted above, many distressed a forthright analysis and convert or [email protected]. # NYLJ-09252019-417218